'Red ocean market': VCs wary of investing in app companies

Why are venture capitalists often reluctant to invest in companies that make apps?

"Because it's a red-ocean market. There's so much competition, it's inevitable that there will be blood in the water," said Tom Kinnear, a professor of business administration at the University of Michigan.

Kinnear is something of a legend in local entrepreneurial circles. An active angel investor, he sits on the boards of the Ann Arbor Angels investment group and Michigan Venture Capital Association, chairs the board of the state's Venture Michigan Fund and advises several venture capital firms in Ann Arbor.

"There's a plethora of apps," Kinnear said, "and the question is, what is unique about yours that is not easily duplicable by someone else? And will you be able to grow big enough to bring the exceptional rate of return venture capitalists need for their limited partners?"

The answers to those two questions, too often, are "nothing" and "no," he said.

App companies are often able to readily raise seed money from friends, family and angel investors to start their businesses. But once they're on a growth track and have shown some market acceptance for their apps and that they need money to grow, they have trouble getting funded by venture capitalists.

It's not that a gap in available funding exists. It's that many app companies have products that, while they may make a profit, don't look likely to have the kind of dramatic growth the VCs need to make the kinds of returns they want for their limited partners when they sell their portfolio companies.

David Brophy

David Brophy is director of the Center for Venture Capital and Private Equity Finance at UM's Stephen M.Ross School of Business. He also founded the MichiganGrowth Capital Symposium, which this month had its 33rd annual event in Ypsilanti. Venture capitalists from around the country came to hear pitches for capital from 32 Midwestern entrepreneurs, several of them app-based companies.

Brophy said that a lot of app companies get launched by college students because they are in an environment that treasures smartphones and apps, giving those would-be entrepreneurs an inflated sense of what the market reception will be in the real world.

"They enter some business plan competitions when they're still in school and win a couple of thousand dollars, and they think they have a business," Brophy said. "But when they are approached by long-term investors, they often don't have good answers to the questions they get. They haven't done the blocking and tackling of building a company."

There are exceptions to the rule that VCs are leery of apps, Kinnear said. Venture-backed app companies like Waze, an Israeli mapping app, sold to Google for $966 million; Mailbox sold to Dropbox for $100 million a few months after launching; Instagram sold to Facebook for $1 billion. And in the biggest headline-maker of them all, WhatsApp sold to Facebook for $19 billion.

"WhatsApp was sold for billions because it quickly became the place to go if you wanted to send texts anonymously, and a lot of people do," Kinnear said. "But generally, it's just very, very hard to differentiate yourself."

VCs ask those making pitches about the barriers to entry for would-be competitors. With medical devices, it might be patents or a method of fabrication that is almost impossible to duplicate easily.

"There's a reason the app space is hot and mobile is hot," said Chris Rizik, CEO of the Ann Arbor-based Renaissance Venture Capital Fund. "The challenge is, with the thousands of apps being developed, why is this one unique? Does it fill a real need?

"What makes it even more difficult is the barriers to entry are so low. The tools you need to build apps are so cheap, it makes competition even easier."

Lindsay Aspegren, managing partner of Ann Arbor-based North CoastTechnology Investors LP, has invested in Ann Arbor-based Larky Inc., which helps users manage their discount programs, such as those offered by credit card or insurance companies. Even so, he said, the app space is fraught with peril from the VC point of view.

"It's a little bit like being in the record business," he said. "It's so hard to predict who will have a hit record. Apps are very exciting for a consumer, but they're hard to tie to commerce. How do you get a derivative revenue stream? Can you aggregate enough users so it makes sense for someone to buy the company?